The central bank cut its daily reference rate by 1.9 percent, triggering the yuan’s biggest one-day drop since China ended a dual-currency system in January 1994. The People’s Bank of China called the change a one-time adjustment and said its fixing will become more aligned with supply and demand.

The announcement suggests policy makers are now placing a greater emphasis on efforts to combat the deepest economic slowdown since 1990 and reduce the government’s grip on the financial system. Authorities had been propping up the yuan to deter capital outflows, protect foreign-currency borrowers and make a case for official reserve status at the International Monetary Fund.

“The one-off devaluation of the fix and allowing more market-based determination takes us into a new currency regime,” said Khoon Goh, a Singapore-based strategist at Australia & New Zealand Banking Group Ltd. “It looks like this is the end of the fixing as we know it.”

The yuan dropped 1.8 percent to close at 6.3231 per dollar in Shanghai. It slid 2.6 percent to 6.3790 in Hong Kong’s offshore trading, the biggest discount to the onshore spot rate since 2011. The central bank allows the Shanghai rate to diverge a maximum 2 percent from its daily fixing, which was set at 6.2298.

Exchange-rate intervention contributed to a $300 billion slide in China's foreign-exchange reserves over the last four quarters. It also made the yuan the best performer in emerging markets, a factor behind last month’s 8.3 percent slide in exports.

The yuan’s real effective exchange rate -- a measure that’s adjusted for inflation and trade with other nations -- climbed 13 percent over the last four quarters and was the highest among 32 major currencies tracked by Bank for International Settlements indexes.

Market Forces

Effective immediately, market-makers who submit prices for the PBOC’s reference rate will have to consider the previous day’s closing spot rate, foreign-exchange demand and supply, as well as changes in major currency rates, the central bank said in a statement. Previous guidelines made no mention of those criteria.

“The new fixing will be quoted based on the previous day’s closing, which is a real market level,” said Becky Liu, a Hong Kong-based senior strategist at Standard Chartered Plc. “The band will become the real band. This is a big step, and bolder than we expected.”

Tuesday’s devaluation was a one-off adjustment and shouldn’t be interpreted as a sign that the yuan will enter a depreciation trend, PBOC chief economist Ma Jun was cited as saying in a Caixin report. The central bank said it will stabilize market expectations and ensure the new reference-rate mechanism will take effect “in an orderly manner.”

Capital Flows

China has to balance the need to boost exports against the risk of capital outflows, Tom Orlik, chief Asia economist at Bloomberg Intelligence, wrote in a note. He estimates that a 1 percent depreciation in the real effective exchange rate boosts export growth by 1 percentage point with a lag of three months. At the same time, a 1 percent drop against the dollar triggers about $40 billion in outflows.

“The risk is that depreciation triggers capital flight, dealing a blow to the stability of China’s financial system,” Orlik said. China’s leaders may be calculating that they can manage those risks with their $3.69 trillion of foreign currency reserves, he said.

The PBOC said Tuesday that a strong yuan puts pressure on exports and cited a high effective exchange rate as a factor behind the devaluation. July’s export slump was deeper than economists predicted, while the nation’s index of producer prices declined 5.4 percent, the most since 2009.

Deflation Risk

“Today’s sudden policy move is a reaction to a significant weakening of China’s export numbers in July and rising deflation risk,” said Liu Li-Gang, the chief Greater China economist at ANZ in Hong Kong.

While the devaluation will help support growth, Liu is predicting that the PBOC will lower lenders’ reserve requirements in August and cut benchmark interest rates this quarter for the fifth time in a year.

IMF requirements that reserve currencies must be freely usable may have also played a role in the PBOC’s move, according to Commerzbank AG. The fund has said in recent months that the yuan needs to be more flexible.

“The yuan exchange rate will be more market-oriented going forward,” Zhou Hao, an economist at Commerzbank in Singapore, wrote in a report. “Volatility of both the onshore and offshore rates will pick up significantly.”

The yuan’s one-month implied volatility, a measure of swings used to price options, surged 4.8 percentage points, the most since 2004, to 6.01 percent. The gauge had fallen to a one-year low of 0.99 percent on July 24.

Currency War

China’s move has raised the risk of a “currency war” as export rivals seek a weaker exchange rate to stay competitive, according to Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia.

“It’s hard to believe this will be a one-off adjustment,” Roach said. “In a weak global economy, it will take a lot more than a 1.9 percent devaluation to jump-start sagging Chinese exports. That raises the distinct possibility of a new and increasingly destabilizing skirmish in the ever-widening global currency war. The race to the bottom just became a good deal more treacherous.”